From the desk of Tom Bruni @BruniCharting
Two weeks ago I wrote about the downside resolutions in Treasuries and Yen and the questions we would be asking in the days following. Given their rallies in the last week, we continue to ask those questions and observe what messages these “safe haven” assets are sending about the market.
This week’s talk of the town is the “Island Reversal”, and rightfully so, as some of the world’s strongest indexes are sporting this pattern.
Let’s take a look and get into what it could mean for the days/weeks ahead.
Before we get into discussing the implications it’s important to understand the pattern itself, both mechanically and psychologically.
Edwards & Magee give us this definition which I think helps identify the mechanics of this pattern (remember this was written in the 1940s):
Island Reversal – A compact trading range, usually formed after a fast rally or reaction, which is separated from the previous move by an Exhaustion Gap, and from the move in the opposite direction which follows by a Breakaway Gap. The result is an Island of prices detached by a gap before and after…..The two gaps usually occur at approximately the same level. By itself, the pattern is not of major significance but it does frequently send prices back from a complete retracement of the Minor Move which preceded it”
Don’t worry if you can’t picture it in your head or quite grasp this concept (we’ll show you an example below), what’s more important is that you understand the underlying psychology that drives this pattern.
By definition, a reversal first needs a trend to be in place. In this example, we’ll use an uptrend. As prices are moving higher, buyers are rewarded and shorts punished until there’s a gap higher that creates a buying climax as longs rush in and shorts throw in the towel. Following this move, prices consolidate for a period of time during which buyers and sellers continue to place their bets on the price range’s ultimate resolution, but neither supply nor demand are strong enough to resolve it. Finally, supply exceeds demand and prices gap lower, trapping all of the buyers that bought at higher levels. This generally creates a sharp move lower as longs rush for the exits and shorts start, or add to, their positions.
The intensity of the downside follow-through after this reversal occurs typically provides some insight into whether it marked a short-term top or is the beginning of something much more significant. The ability of buyers to reclaim control and close that gap quickly, however, would be a data point that reaffirms the uptrend’s strength.
And so the point of explaining all this is because we’re seeing this pattern play out in several indexes around the world, including the Nasdaq 100. Given it incorporates all three of the factors that equity investors have favored for years: US Stocks, Mega/Large-Cap Stocks, and Growth Stocks…all in one liquid, investable index, it’s no surprise that it was the first to make new all-time highs.
The problem is, in addition to the short-term island reversal in the index, it also closed the week below its February highs…opening up the potential for this to turn into a major failed breakout. The line in the sand is 9,725. Below that level, there’s potential for bad things to happen.
Click on the chart to enlarge view.
Here’s the S&P 500 also putting in its own island reversal after failing at resistance near 3,240. For now, its series of higher lows and higher highs remains intact, so it would take a move below 2,940 to signal the start of something more meaningful.
Here’s the TSX Composite also putting in an island reversal and failed breakout above the 61.8% Fibonacci Retracement of its March-June rally.
Sweden has been a longer-term area of relative strength but is also putting in a failed breakout and island reversal.
And most of these island reversals and failed breakouts are taking place at very logical long-term levels. Here’s the OMX Stockholm 30 failing at multi-year resistance near 1,720.
In the Emerging Market space, India is stuck below a confluence of resistance near 10,000.
Here’s the Russian MICEX getting back to its original failed breakout level of 2,875 and failing.
And here’s the daily chart view failing at its 61.8% Fibonacci Retracement.
Israel isn’t exempt, failing at its gap below long-term resistance at 1,500.
And here’s the 61.8% Fibonacci Retracement keeping a lid on prices.
We’ve also got the Brazilian Bovespa also retesting broken support near 98,750.
And here’s its daily chart failing at the 61.8% Fibonacci Retracement.
Even markets that retraced far beyond their 61.8% Fibonacci Retracements, like New Zealand, are putting in short-term failed breakouts.
Lithuania isn’t exempt, failing to hold above 730 once again.
The “Island Reversal” pattern is getting all the headlines this week, but if you take a look at our entire list of markets across the globe, then it’s clear that there’s more going on here.
Do all of these failed moves lead to fast moves in the opposite direction, marking the start of a much larger correction in Equities? Or do they work through this overhead supply over time and continue higher?
Or is it a combination of both?
Add to the mix a US Dollar finding its footing relative to many non-Euro currencies and you’ve got a set of conditions that cannot be ignored, especially if you own any of these global markets via US-based ETFs.
We’ll be discussing these charts and much more on Monday’s Members-Only Conference Call, so join us live or watch the replay directly after.If you enjoyed this post and want to join this week’s conference call, start your 30-day risk-free trial or sign up for our “Free Chart of the Week” to receive more free research like this.
Thanks for reading and please let us know if you have any questions!